Investment advisor Callan Associates released the annual update to their Periodic Table of Investment Returns:

Callan Periodic Table of Investment Returns 2008

If you’ve never seen it, the Callan Periodic Table shows common asset classes and their returns each year back to 1989. The table doesn’t list all the assets that the Permanent Portfolio uses (it’s missing Gold [+5% in 2008] and US Treasury Long Term Bonds [+33% in 2008]), however it gets a point across. What point is that you ask?

The markets are not predictable – Something you’ll hear me repeat over and over again on these pages. 

This table shows some assets doing well for a couple years and then falling from grace. Then the losers rise to carry the title of hot performer until they finally go down in flames. This is the way of the markets. In fact, Harry Browne used to say:

“Investment success begins the day you accept the fact that you cannot predict the future”

This is excellent advice. 

The benefit of the Permanent Portfolio strategy is you’ll usually have an asset doing well no matter what is going on in the economy. This asset can often offset your losses in the other parts of the portfolio or at least dampen serious losses. To capture your gains, the strategy has you selling down your winners and putting that money into the under-performers which may do well going forward. The net result is a smooth stable growth through the years without the volatile gut wrenching swings in portfolio value.

All of this can be done without turning yourself inside out relying on fortune tellers, market timing, predictions, chart analysis, reading mountains of investment news and hoping that your risky gamble doesn’t leave you in the poor house. Once you accept that the markets cannot be predicted you are able to adopt an investment strategy to deal with this uncertainty and sleep at night.

Market timing doesn’t work, but it’s not the end of the world. In fact, this realization is critical to investment success. So let go and trust the Force, Luke. You’ll be a better investor for it.

Risk and reward go hand in hand. The more reward you expect, the more risk you are taking. This has always been true and always will be true. 

But with risk comes the possibility of losses and avoiding large losses in a portfolio can be just as important as reaching for big gains. The way the math works, large losses do a disproportionate amount of damage to a portfolio (e.g. a 50% loss means you need to earn 100% just to get back where you started).

If you are curious about what kind of returns you need to recover from a serious portfolio loss I recommend you consult this handy table:

Getting Back to Even

This is just some food for thought about consequences of investing risk. Understanding risk is a critical component to developing an investment strategy you can stick with when markets aren’t going your way.

Economist Robert Higgs comments in the following piece about the prospect of inflation in 2009 and beyond:

The Fed versus the Banks: Who Will Blink First?

I have never been inclined toward touting doomsday financial scenarios. I raise the possibility now only because, as I consider the situation portrayed in the graph of excess reserves linked above, I am unable to foresee how the Fed and the Treasury can navigate through these treacherous waters – waters that their own previous actions have whipped to a foam – without creating terrible financial and economic harm. If the dollar survives the ministrations of Bernanke, Paulson, Bush, and the Obama gang, its survival will be something of a miracle.

Earlier in 2008 inflation fears were the bogeyman. Oil was at $150 a barrel (it’s now $40). Gold hit $1000 an ounce (it’s now in the $800′s). And the Dollar was at record lows against the Euro and other world currencies (it recovered greatly). The markets were sure that inflation was coming on strong. 

Ahhh, but Fall 2008 came and so did the popping of the Real Estate bubble. This caused a massive destruction of paper wealth that rippled through the financial markets taking out many large banks. By December, Long Term bonds (a powerful deflation shield) swapped places with gold, commodities and other inflation hedges for being the winning asset of the year. The US Dollar shot up in value at a rate never seen against the Euro. Deflation was on everyone’s mind and Long Term bonds proved their mettle as they powered ahead with 30-40% gains. This boost erased almost all market losses in the Permanent Portfolio strategy during the October/November stock crash.

Who would have thought that we’d start 2008 with the prospect of inflation only to end the year with our illustrious central bankers scrambling to prevent an all out deflation? The markets are like that though. Moody. Random. Unpredictable. 

But what should we do now?

Stick to the plan.

If you follow the Permanent Portfolio strategy you’ve probably done OK so far considering how bad the markets are. Perhaps you’re down only a couple percent compared to the 40% loss in the general markets. You dodged a bullet and may be feeling pretty good, but don’t get complacent!

During this time as stocks swooned your Long Term bonds have soared. You are probably finding that your bond allocation is now at or above your rebalancing bands in the portfolio. They could likely be 30, 35 or even 40% of your allocation. Yet, your stocks may have fallen by 40% and could be only 15% or so of your portfolio.

That’s not good. It’s now time to rebalance. 

If you are overweight on your bonds in the portfolio (e.g. they exceed 30-35% of your holdings), you should consider selling them down to 25% and using the proceeds to bulk up the other parts of your portfolio that are below the 25% allocation band (such as your stocks, cash and gold).

For those thinking their bonds have done great and don’t intend to rebalance, all I can say is be careful. It’s tough to sell a winning asset, but at any time your bond gains could be eroded as interest rates whipsaw upwards. If economist Higgs is right, the inflation we see could be quite bad. Instead of 30-40% profits in your bonds, you could be staring at 30-40% losses or worse. 

By not rebalancing, you may miss out on large gains in your other assets by having too much of your money tied up in your current winners. Imagine missing out on a 20%, 30% or higher gain next year in stocks if the markets recover and things work out. 

YES, I know that sounds impossible right now. But it’s happened before and YES it usually does it after a bad market crash.

Gains like I just mentioned happened after the early 1970′s recession (1975 +37%, 1976 +24%), after the recession in the early 1980′s (1982 +21%, 1983 +22%), after the early 1990′s recession (1991 +31%), after the early 2000′s Internet bust (2003 +29%) and they even happened during the 1930′s Great Depression (1933 +54%, 1935 +47%, 1936 +34%, 1938 +31%).

Virtually nobody during these years was predicting a big bull market would happen right in the middle of those bad economies. Yet, they did. If you find your stocks are up +40% next year that’s great. You’ll be selling off those profits to buy your new losers. That’s the essence of rebalancing. Same for any gains in your gold or even more gains in your bonds. If the markets turn against this year’s winner at least you’ll know you took those profits off the table and put them somewhere more productive before they had a chance to vanish. 

This is not a prediction (I don’t do predictions). Just a reminder that the markets do crazy and unpredictable things so you need to own all of the Permanent Portfolio assets and not try to guess what may happen. Be unemotional about rebalancing out of winners to buy your losers. 

One final note is that taxable investors may want to take the time to do a tax loss harvest on stock funds that are underwater before the end of the year. You can use these losses to offset their taxable gains going forward. If you don’t have any losses to take, it may make sense to wait until 2009 to take the Long Term bond gains to defer the taxes until next year. Talk to your accountant to see what option makes sense. Investors in tax-deferred retirement plans don’t need to worry about this. 

Harry Browne advised that  you should invest the money you can’t afford to lose in the Permanent Portfolio strategy. This strategy, as discussed in his books and on this site, provides stable returns with low volatility year after year with enough diversification to protect against large losses of capital. It’s boring, yet profitable. 

But what if you think you can beat the market? What if you want the excitement of stock trading? Suppose you have some money you can afford to lose? What to do? Simple: You want a Variable Portfolio.

The Variable Portfolio is for speculation and is done with money you can afford to lose. This is money that if you were to wake up tomorrow to find it gone it wouldn’t affect your retirement plans, children’s college savings, home down payment, etc. It’s money that you’re willing to gamble on losing or striking it big.

What Investments to Hold in the Variable Portfolio

The Variable Portfolio can hold any investment you feel like. Speculative penny stocks, hot sector bets, art work, your cousin’s Amway franchise, whatever. Use any market timing scheme you think sounds good. Follow the advice you see on the TV or read in a magazine. Go to Vegas with it. It doesn’t matter, but there are a couple basic rules you need to follow.

The Rules of the Variable Portfolio

The Variable Portfolio has two basic rules:

I also adapted a third rule expressed in the 16 Golden Rules of Financial Safety  just to clarify things:

• You can’t use margin or take other risks that could cause you to lose more money than you put into the Variable Portfolio investment. 

I add this third rule because, to me, this would include some strategies like shorting securities which can cost you more money than your initial position if you’re wrong. In my opinion, you should not have short positions in the Variable Portfolio nor should you include investments that can cost your more money than the initial sum if you’re wrong (which some business investments can do, so tread cautiously). 

The Variable Portfolio can be any percent of your entire investment portfolio you feel comfortable losing. In other words, the Variable Portfolio could be 10% and the Permanent Portfolio could be 90% of your savings. Or it could be 50/50. Or it  could be zero percent because you don’t have money you can afford to lose or just don’t feel like speculating. 

A Variable Portfolio for “Modifying” the Permanent Portfolio

A common question about the Permanent Portfolio is about “modifying” the asset allocation from the 4 x 25% split to something else. While I think the allocation works fine as is, if you feel like modifying the Permanent Portfolio you should count it as part of your Variable Portfolio. Do you think you should hold more than 25% in stocks? Fine. That’s part of your Variable Portfolio. You want to hold more bonds or some REITs? Fine. That too is part of your Variable Portfolio. Same for gold and cash. These changes also fall under the rules listed above.

The Variable Portfolio Helps Keep Your Hands off the Permanent Portfolio

The Variable Portfolio is a critical component to the Permanent Portfolio strategy because it allows you to wager money (if you choose) in a way that can’t compromise your core savings if you are wrong. It’s like having some “Mad Money” in  your budget for spending on whatever you like without blowing your expense account. 

You can use a Variable Portfolio or not. It’s not required, but is there if you feel like doing a little gambling if you can afford to do so.

Can I Beat the Market?

The markets are hard to beat as many investors have found out to their dismay (and loss). Before you get too gung-ho on the Variable Portfolio, I leave you with this quote from Harry Browne in his book Fail-Safe Investing summarizing the odds of beating the market:

Even investment professionals don’t generally beat the markets. The Hulbert Financial Digest tracks the results achieved by the published model portfolios of hundreds of investment newsletters — written by people who spend 8-12 hours a day watching and studying the investment markets. 

Each year only a handful of newsletters outperforms the Dow Jones Industrial Average. And the handful changes from year to year, so there’s no way to know which advisor will have a “hot hand” in the coming year. 

Professionals are consumed with the job of tracking investments, and they have easy access to far more information than you do. If they can’t consistently beat the investment markets, how can you? The answer is: you probably can’t. 

If you want to speculate and try to beat the markets, only do it with money you can afford to lose in the Variable Portfolio. The Permanent Portfolio is for your money that is precious to you, not for speculating. 

Let’s get to the meat of any investment strategy: How well does it actually work?

In a prior post we talked about the Permanent Portfolio allocation which is:

25% – Stocks (in a broad based stock index fund like the S&P 500)
25% – Long Term Treasury Bonds
25% – Gold Bullion
25% – Cash (in a Treasury Money Market Fund)

This allocation will provide protection when the economy shifts through the cycles of prosperity, inflation, deflation and recession.

Now, some may be thinking that this allocation sounds very different than what they’ve seen elsewhere. For instance, the idea of owning gold is scoffed at by some investment advisors because it has no dividends or interest. Long Term Bonds? Many will tell you that they’re too risky due to rising interest rates. How about Cash? Isn’t holding a bunch of cash missing out on the hot stock market action? And, only 25% in stocks? Well everyone knows that stocks always beat every other investment so surely you want more than 25%, right? Right!?

Not exactly.

The reality is the investment markets are uncertain and unpredictable. What may look good in a theoretical backtest may blow up horribly as economic conditions change. Even worse, portfolio strategies that should work well based history often don’t work in actual application as people abandon them due to volatility and long periods of underperformance. Finally, every reputable study on the subject has shown that relying on your gut instinct, hunches, investment gurus and hot tips to run a portfolio is a road to disaster for performance and safety.

The Permanent Portfolio strategy works because it has very wide and true diversification. You have exposure to assets that can grow your money safely at all times without having to predict the future. You also have protection in the diversification against losing large amounts of money which can cause you to abandon the strategy in bad markets.

A Couple Small Changes

I did make two small changes to the original Permanent Portfolio as investment vehicles have changed in type and availability over the years. Harry Browne recommended using the Treasury Money Market Fund for cash. I personally like using Short Term Treasuries in combination with a Treasury Money Market Fund which provides nearly identical risks but slightly better returns on your cash. Also, instead of using the S&P 500 Index, I’ve chosen to use the Total Stock Market Index(also called the Russell 3000, or Wilshire 5000 index). The Total Stock Market Index provides wider stock diversification (holds 3-7000 stocks) with slightly better results than the S&P 500 (which holds 500 stocks). The slightly better result is because the Total Stock Market also holds small and medium sized company stocks which can sometimes outperform the large company stocks of the S&P 500 alone. The Total Stock Market also has expected higher tax efficiency due to how the index is constructed and managed.

You can use my changes or not. It doesn’t matter much. If you stick to the S&P 500 and Treasury Money Market Fund as originally recommended the results are within about 0.50% (one half percent) annually (favoring short-term bonds and total stock market) through the years.

Historical Returns

Let’s look at the score card and see how the Permanent Portfolio Allocation has done the past 36 years from 1972-2008 (1972 is the furthest we have data for Gold which was taken off the fixed exchange rate in 1971).

The assumption in this table is we rebalance each year to get back to our 25% allocation split among all four asset classes. In the table below I’ve highlighted in Red the asset that did the worst in a particular year and Green for the asset that did the best. Note that “worst” does not mean the asset was necessarily negative, just that it was the lowest performer for that particular year. In the average column I highlighted in Orange any year with a loss for the portfolio.

Data pulled from the Simba Spreadsheet on the Diehards Forum. Gold returns pulled from: http://www.finfacts.ie/Private/curency/goldmarketprice.htm. NOTE: Gold prices were largely fixed before 1971 and tied to the dollar. So the prices of gold did not move according to market fluctuations much before 1971. 2008 values pulled directly from market indicators. LT Treasuries for 2008 reflects owning 25-30 year treasuries directly and not the market index 20 year benchmark (which the portfolio is not designed to use).

Results

The Compound Annual Growth Rate (CAGR) is 9.7% for the entire period.

The worse loss for the portfolio in any one year was 1981 which had you down only about 4%. The market problems through the decades were barely registered in the final return each year. This means the portfolio was able to provide these solid and stable returns with very low volatility and risk.

You’re probably wondering how this portfolio compares to other strategies. The Permanent Portfolio was able to rack up the following returns against these competitors if you invested $10,000 back in 1972:

Now, some might be thinking: “Hey, gold was price controlled before 1971 so it’s not fair using 1972 as the start because the price of gold shot up. It made it look better than it really was!” (OK, maybe you weren’t thinking that, but I was because it’s true and we need to consider its impact). We’ll start a couple years out in 1974 then, enough time that the gold market would have settled out:

The Permanent Portfolio allocation is always competitive with the 100% stock allocation and the 50/50 bond allocation. Anything within +-0.50% of each other is essentially market noise that can easily flip back and forth each year.

The most important part is the Permanent Portfolio never had wild gut wrenching swings in value. In 1973-1974 stocks lost 50% in value. In 1987, stocks dropped 25% in one day. During the 2000-2002 Internet bubble crash, stocks dove about 40% over two years and the NASDAQ dove 80%! In 2008 stocks were down about 40% for the year.

Yet given all the above the Permanent Portfolio was able to produce positive returns during these very bad markets. Most recently in 2008 we had the worst single year market crash since 1931 and the portfolio still squeezed out a 2% profit for the year. The Permanent Portfolio allowed you to avoid all those disasters but gave you performance on par with the far riskier 100% stock allocation.

Even better, the Permanent Portfolio was able to provide real after-inflation returns during some times when the stocks and bonds couldn’t (such as the decade of the 1970′s). This means that even though inflation may have been killing your stocks and bond returns (by giving you negative real growth even though they went up in value), the Permanent Portfolio was able to go above and beyond by several percentage points to give real results that weren’t being eroded by a falling dollar.

Take a look at the returns table above and notice how you’ll always have one asset class doing very well and one doing flat or badly. Isn’t that counter-intuitive that you should be able to profit from that type of movement? Nope. It’s diversification in action. The way the Permanent Portfolio uses its assets to diversify according to economic conditions is what makes it work so well.

We’ll talk more about this in the future.

Harry Browne and Terry Coxon formally introduced the Permanent Portfolio in their 1981 book entitled: Inflation Proofing Your Investments. Like most great ideas, the Permanent Portfolio was simple, but was not simplistic.

The Permanent Portfolio investment strategy is the first one I’ve seen that developed an allocation based on economic cycle analysis. The Permanent Portfolio idea separated these economic cycles into four basic categories:

1. Prosperity
2. Inflation
3. Deflation
4. Recession

At any one time the economy will be in one of these phases or transitioning from one phase to another. This is the secret of the strategy and why it works. The strategy does not attempt to predict when these things happen or guess how long they may last. Instead, it holds specifically chosen asset classes that respond well to these cycles no matter when they happen or for how long. 

By 1987, Harry Browne took the more complicated asset allocation presented in his and Coxon’s first book above and refined it to make it easier to implement. This version of the allocation was presented in his book Why The Best Laid Investment Plans Usually Go Wrong (Find a used copy if you can. Like all of Browne’s books, it’s a must read.). The allocation remained the same in all his investing books that followed. Here it is (Preferred investment vehicle in parentheses):

• 25% – Stocks (S&P 500 Stock Index Fund)
• 25% – Long Term Bonds (US Treasury 30 Year Bonds)
• 25% – Gold (Physical Gold Bullion)
• 25% – Cash (Treasury Money Market Fund)

These assets are always present in the portfolio in a balanced way no matter what is going on in the economy. Why were these assets chosen? Because they respond to the four economic cycles listed above:

• Stocks – During prosperity, stock Index funds capture the full market returns available.
• Long Term Bonds – During times of deflation, US Treasury long term bond prices will go up quickly in value. Bonds also do reasonably well during prosperity. 
• Gold – During bad inflation, gold bullion is the only asset that provides strong protection against a falling currency. 
• Cash – During a recession, no particular asset class is going to do well. The cash in a Treasury Money Market Fund acts as a buffer for losses while the markets adjust during these relatively short times of underperformance. It also does well during deflation. 

Remarkably, these four asset classes are all you need to handle good and bad markets. Again, it’s simple but not simplistic. 

Even better, this allocation provides safe growth of your money. This means you won’t have to worry about the crazy swings in the stock market that may cause large losses of your life savings.

In fact, over the 30+ year history of this portfolio strategy the worst loss it ever had was about 4-6% in 1981 with an annual growth of 9-10% since 1972. The portfolio has prospered and protected its money through bear and bull markets alike. 

What this means is the Permanent Portfolio strategy will move along through the years providing stable and secure growth. 

How stable and secure? We’ll talk about that in my next post. But I feel if you combine the Permanent Portfolio with the 16 Golden Rules of Financial Safety you will have a very solid investing foundation that will get you to your ultimate destination in one piece. 

In the meantime, if you haven’t purchased a copy of Fail-Safe Investing you should really consider doing so. This book explains the method to the strategy in a very easy to read and understand form. My postings here will clarify some common questions, provide you with insight into ways to implement the ideas, and delve deeper into the economic mechanisms that make the portfolio work. 

Harry Browne also discussed the Permanent Portfolio Allocation in this radio show link.

Fail-Safe Investing